Hidden reserves are those components of equity that are not shown in the balance sheet, which can arise on the one hand from an overvaluation of debts or an undervaluation of assets.
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Definition / explanation
The hidden reserves are hidden but still legal assets of companies which, contrary to the other accounting principles, are not exactly disclosed. The main reason for the creation of hidden reserves is the principle of prudence in the balance sheet:
Raw materials, intermediate products and other items may only be accounted for at historical purchase prices.
Hidden reserves and the “going concern” principle
Even before the modernization of the accounting system in line with international standards, the legislature decided on some basic functions of the balance sheet: On the one hand, it should present an actual picture of the financial position (and also the debt) of a company. On the other hand, the normal annual balance sheet aims to describe the values as precisely as possible in the event of a going concern. Therefore, the focus is on mapping the entrepreneurial value creation processes and not on market speculation.
Creation of hidden reserves
Purchased raw materials and materials are further processed within the company and are on the balance sheet with their purchase value in the finished goods until they are finally sold. The profit from your own added value and the profit from the sale on the market can only be offset when payment has been received from the customer.
Therefore, there are always certain cost components and items of current assets as hidden reserves in the balance sheet. This is also due to the principle of prudence, according to which a balance sheet should not overestimate assets.
For many manufacturing companies, this also makes sense in the long term because, for example, the reversal of the value of the property in an industrial area is often only of a purely fictitious nature. If the costs of a relocation were deducted, the original valuation is far more realistic than a value during a boom real estate phase.
Types of hidden reserves
- Silent compulsory reserves
- Hidden discretionary reserves
- Hidden valuation reserves
- Hidden arbitrary reserves